flow mechanism

Wednesday, January 1, 2014

Nick Rowe has an interesting post on the asymmetry in taboos surrounding labor relationships. He argues that we tend to consider it morally wrong for employers to fire their workers and replace them with others, but not find it very disagreeable for workers to stop selling their labor to their employers in order to take a job somewhere else. Moreover, the latter can simply be done - no questions asked -, while the former even involves a legal requirement to prove "just cause" for dismissal. This means that the bargaining power of workers and employers may be affected by this asymmetry:

Nick's Law of Relative Bargaining Power: any exogenous change in relative bargaining power will cause some change in the market that restores the original level of relative bargaining power. If there is a taboo against employers quitting workers but no taboo against workers quitting employers, and if people fear breaking taboos, then something else will change that re-equilibrates the fear.

I would say that one thing that might equilibrate the relationship is wages: in some sense, the lack of moral outrage at employees walking out on their employers should make it harder for employees to prove to employers that they are serious about not walking out on them as soon as they get a better offer. The result should be that wage contracts contain more elements to reassure employers of workers' sincerity, such as low entry wages and steeper wage schedules, or longer unpaid internships or trial periods before full-time work and benefits are offered, as well as rewards for investing in firm-specific rather than general (and portable) human capital. At the same time, the asymmetry in moral outrage should result in more unemployment for those who failed to overcome firms' apprehensiveness.

This reminds me of an interesting argument I once heard in the debate about outsized CEO salaries: making executives the target of public shaming and zealous scrutiny of their private lives should raise not lower CEO salaries, as CEOs will need to be compensated even more richly for working under such stressful conditions. That is, the public campaigning against outsized CEO salaries achieves the opposite of its stated goals.

A similar mechanism may be at work in this more general example: if we make it hard for firms to fire employees, they will be reluctant to hire them, and therefore protections for employees may paradoxically endanger their employment, even if the protection is of a "moral" and not a "legal" nature.

Tuesday, October 8, 2013

Maybe we should start preparing. And not just by wringing our hands or mounting attempts to defeat surveillance. For if there’s a chance that the panopticon is inevitable, we ought to do some hard thinking about its positive aspects...If calibrated properly, total surveillance might eradicate certain types of crime almost entirely. People respond well to inevitable consequences, especially those that follow swiftly on the heels of their conduct.

This is interesting stuff and he touches upon some important insights: perfect monitoring of someone's movements would make enforcement of all sorts of contracts easier, as compliance or breaches would be easily observed. I think an important consequence of this would be greater prosperity: resources that are currently wasted on signaling due to asymmetric information (e.g. carefully nurturing good credit scores to prove one's responsible lifestyle choices) could simply be replaced by a glance at the surveillance record. Moreover, prices of information-sensitive products, such as insurance, could be better adjusted to the true risk of an individual, as more information would improve the accuracy of the risk assessment.

However, I also think that there is a major drawback to increased surveillance that might outweigh all the positives that Armstrong touches upon: The abuse of the information by those doing the surveilling. There are a lot of laws on the books that are rarely enforced (e.g the prohibition of wagering more than $2000 in a day between friends in Virginia), but that would - given the ability to find out minute details about everyone's lives - enable someone to punish almost anyone if they chose to enforce them. This kind of selective enforcement by government officials is a real threat - not necessarily as a matter of top-down policy, but rather as the result of power and temptation in the lower ranks (think "surveillance officer finds that his ex-wife's lover does not obey the rules on kissing with a mustache and sends him a SWAT team").

Interestingly, Armstrong sees this problem from the opposite angle: as surveillance makes everyone liable to enforcement of these laws, he thinks that they will be swiftly abolished, thereby increasing personal freedom:

But if everyone was suddenly subject to enforcement, there would have to be a mass legal repeal. When spliffs on private yachts are punished as severely as spliffs in the ghetto, you can expect the marijuana legalisation movement to gather steam. When it becomes glaringly obvious that most people simply can’t follow all the rules they’re supposed to, these rules will have to be reformed.

My instinct tells me that this is overly optimistic: instances of government authority becoming overly burdensome and therefore being promptly abolished may exist, but they are rare, to say the least.

Friday, July 19, 2013

I recently read the paper "Public policies against global warming a supply side approach," by Hans-Werner Sinn, in which he coins the term "green paradox" to denote the phenomenon that some policies proposed against global warming may have the perverse consequence of increasing CO2 emissions once we take into account the response by resource suppliers. I will show one example of how this might happen and talk about some implications for designing policies intended to decrease CO2 emissions.

In order to understand the core of Sinn's argument, we will abstract from various complications that might weaken or strengthen his result, but that do not change the fundamental point that perverse CO2 emission responses are at least possible, even if not likely. That is, we will assume that resource extraction technology and the total stock of extractible resources (e.g. oil reserves in the ground), as well as the interest rate, are given and constant.

In that case, we can think about the problem of a resource producer, e.g. a global oil company, in the following way: If the oil producer leaves the oil in the ground today and sells it tomorrow, she gains if the price of oil increases in the meantime, so that she can sell it at a higher price tomorrow. The return of that is ΔP, the change in the oil price per time unit. If she extracts the oil today, she would have extraction costs c, earn price P, and then be able to invest the net profit for a per-period return of i(P-c). Thus, in any given period, the oil producer will adjust the resource extraction path until

i(P-c)=ΔP

which implies

i=ΔP/(P-c) (1)

To see that this is true, consider what happens when this equation does not hold: For example, if the current price level is such that the expected increase in price over time, and therefore the return to leaving the oil in the ground is lower than the returns i that can be had elsewhere, then the oil producer will try and sell more oil now, in order to invest his money at those relatively favorable interest rates. However, this will increase the current supply of oil, which in turn lowers the oil price. As the amount of oil in the ground is fixed this means that there will be less oil left to be extracted in the future, which raises the future price of oil. As the current price of oil goes down and the future price goes up, the expected increase in the oil price per period increases, which raises the return to leaving the oil in the ground (the RHS of equation (1) above). This will continue until equation (1) holds, because at that point there is no gain to be had from transforming oil int eh ground into money that can be invested or vice versa.

In order to give an example of what this dynamic might look like, I have built a small model of the optimal extraction path (see footnote 1 for further details): Let's assume that the market price of the resource, say "Oil," is negatively related to the amount that is extracted in a given time period, but that the total amount of oil in the ground is fixed and that all oil will be produced within 10 time periods, with zero extraction cost, for simplicity's sake. All prices are assumed to end up at 10 in the last period, which is a stand-in here for the price of the last drops of oil right before the exhaustion of the resource. Moreover, the opportunity cost of keeping oil in the ground is assumed to be 10%, which means that the optimal extraction path following equation (1) will adjust extraction so that the increase in the oil price per period is also 10%. That optimal extraction path is shown as the dark green line R1 in Figure 1 below and the price path that it determines is the light green line P1. Note that the oil producer produces more oil in the beginning and less later, which is why the price rises towards the later periods.

Now, let's ask ourselves what would happen if we threatened the oil producer with constant taxes on oil extraction profits? Because the exogenous interest rate still determines the optimal price path, and remains unchanged at 10%, the extraction path R1 that we initially determined is still optimal. In some sense, as the tax is constant over time, the oil producer has handed over a share of his lifetime oil extraction profits to the government, but the problem of maximizing the value of his remaining share is the same as that of optimizing his extraction path if there were no tax. That is, a constant tax rate on oil extraction profits would not change CO2 emissions at all in this very simplified model. While the setup here is certainly unrealistic, it is not necessarily more so than most of the discussion in the media of climate change policy. And it suggests that at least under some conditions, taking into account the supplier's incentives can undo the intuition that might equate a rise in tax on oil production with a decline in CO2 emissions.

Figure 1

However, some carbon policy proposals go farther than that: they propose raising carbon taxes over time. Now, let's assume that at least some of those tax increases would fall on the oil producer, and is explicitly taken out of his profits after she sells the oil at the market price - you can also think about this as an increasing discount in the form of a rebate or voucher that the oil producer has to give his customers, who would be willing to buy the oil at the market price otherwise. As a result, the optimal extraction path is now determined by

i=(ΔP/(P-c))-Δ/, (2)

where is the level of the tax rate and the additional term on the RHS expresses the fact that any increase in oil revenue that can be had by leaving the oil in the ground for another time period will be mitigated by the increase in the share of profits that are taken away by the tax. Thus, if the interest rate on the LHS of equation (2) remains at 10%, but the tax rate grows by 15% every period, the price of oil would have to grow by 25% in order for the equation to hold. That is, the oil supplier will want the price path to be steeper to make it worthwhile for him to wait until she can sell his oil, if the future brings ever higher tax rates. Put differently, as later oil extraction will be less profitable due to rising taxes, she moves some of the extraction to earlier time periods to escape the higher future tax rates, and as a result current oil prices fall, while exhaustion price in period remains the same, steepening the price curve. This is shown in Figure 1 by the red extraction path R2 and the light blue price path P2, which result from using the same model as above, but replacing the required rate of price increase with 15%.

Let's note what this means: the policy of increasing carbon taxes over time, which is supposed to lead to lower carbon emissions than no taxes or constant taxes, in fact leads to more oil extraction in earlier periods, which means higher, not lower, carbon emissions than without the tax increases! Of course, this model abstracts from many things, among them the possibility of switching to new technologies, which is often one of the goals of carbon taxes. All I wanted to show here is that Sinn's paper suggests that including the suppliers' incentives in our CO2 emission policy analysis may lead to policies having the inverse of the intended effect in this simplified setting. As a result, when reading of any analysis of the impact of policy X on carbon emissions, it might be worthwhile checking whether the results take into account the incentives of resource producers, and, if not, take its policy recommendations with a grain of salt.

While Sinn's model assumes that the "resource suppliers" are a single entity that is free to alter its extraction path any time, the case of oil production would require us to model more complex market characteristics: most major oil producers are members of the OPEC cartel and therefore bound by production quotas that are intended to keep them from increasing their oil production unilaterally in a way that would lower the oil price received by all other producers. Then, the question becomes to what extent OPEC itself can be seen as an optimizing agent in Sinn's sense. On the other hand, there are other factors that might accelerate or decelerate oil production - some of which Sinn mentions: If a country faces an unstable political situation, the current government might not be able to profit from the national oil company's revenues after it loses power and therefore prefers earlier oil production to later oil production. Moreover, if a substantial share of the fiscal budget of a country comes from oil revenues, fiscal deficits may lead to an attempt to raise more revenues from oil production in the short run. In the end, the supply side response to expectations of the future profitability of oil extraction might be quite complicated, but that is no reason to ignore it.

FN 1:
1. The model used is the following: P=a-1.2*R, where a is chosen to ensure that (aggregate resource extraction)=(resource stock in the ground)=50.
2. i1=10% for the first pair of lines and i2=25% for the second pair of lines.
3. Then, equation (1) determines the price path, with exhaustion price set exogenously at P(t=10)=10.

Thursday, July 4, 2013

Emily Badger at The Atlantic recently summarized a new proposal for dealing with the problem of how to pay for clearing away the abandoned buildings that stay behind when the corporations that built them are no more:

"You can't force companies that no longer exist to pay for dismantling these buildings. But what if the government required them – years earlier – to buy property insurance to do that? Think of it as life insurance for commercial sites. ...

...A similar solution already exists for landfills, mining sites and oil rigs. In some communities, companies must also put up bonds on new cell phone towers to ensure that they eventually come down (no one wants an abandoned cell phone tower to tip over). ...

...In short, force companies to financially plan for a property's end-game, and it could change how they think about every stage of the building's life."

While this may sound like a good idea, I will argue that it neglects some important considerations, while raising some important questions regarding the purpose of public policy.

First, let's be clear on what this policy does: by requiring companies to take out insurance or put up a bond to pay for the removal of any structures that may remain after the company's demise, the policy would impose some of the cost of a company's failure that is currently borne by all local taxpayers in advance on any company that wants to build a factory, office building etc. In other words, it is a tax on companies that want to invest locally in a way that requires a building.

The main reason why this might be a good idea according to the paper by LaMore and LeBlanc is that empty buildings that might be left behind impose a negative externality on the community that has to remove them, and decrease the desirability of the surrounding neighborhoods.

However, does the fact that a negative externality exists always justify taxing that activity - in this case building factories? Only, if the negative externality is not outweighed by the positive externalities of the activity. And in this case, the presumption should be that the positive externalities are large: not only may the investment of capital into factories and buildings increase the productivity of a firm's workers, but the establishment of local production facilities usually has a positive impact on the economic activity of surrounding areas as well. The best evidence for that is probably the fact that many cities have policies in place that subsidize companies that are willing to invest in building factories nearby.

As a result, we have to weigh any negative externalities of companies investing in new buildings against the positive externalities and only then can we know whether or not to encourage (subsidize) the activity or discourage (tax) it, but doing both in an offsetting way is certainly not advisable.

As the insurance payment for buildings would be higher in regions that are more likely to suffer from economic problems and the resulting empty buildings, the intended policy would make it more expensive for companies to expand into exactly the struggling areas of the country that are most in need of investment, while encouraging them to crowd even more into metropolitan areas like New York City, where the resale of a company building is almost certain and the insurance premium accordingly low. Regional inequalities may be exacerbated as a result.

Last but not least, the administrative deadweight cost of having to evaluate, administer and enforce the insurance requirement for every privately built structure might be quite considerable - and the interest groups (e.g. insurance companies) that would thrive on an expansion of this policy would lobby strongly for these costs to ever increase.

Overall, I think it is unlikely that such a policy would be beneficial due to its negative impact of discouraging investment in less affluent regions of the country. After all, factories and other company structures are very different from "cell phone towers" and "oil rigs" where such insurance schemes may be appropriate: factories are embedded in economic communities, and, as nodes of local production networks, their investments and increases in productivity have positive externalities due to supporting "specialized providers of industry inputs, thick markets for specialized labor skills, and information spillovers" (Krugman, 2010).

Tuesday, October 23, 2012

Responsibility for turning an ordinary downturn into a depression of unprecedented
severity lies primarily with the managers of the Federal Reserve System.
They failed to carry out their duties as the residual supplier of liquidity to
the public and to the banking system. The U.S. money supply imploded by
30 percent between 1930 and 1932, dragging the economy and the price level down with it. When that happens even AAA credits get to look like
junk bonds.

That is from his Nobel Lecture in 1990. Yes, that is indeed the Nobel-winning Miller of Modigliani-Miller fame who spent most of his career at the University of Chicago calling for intervention by the Federal Reserve. Because he gets it: There is no 'non-intervention' by the Fed - monetary policy always is 'something and the market is freest and most efficient when it is predictable with regard to stabilizing the macroeconomic variables of interest.

Ironically, he did not think that Federal Reserve could fail again in similar fashion as it did during the Great Depression:

That such a nightmare scenario might be repeated under present day
conditions is always possible, of course, but, until recently at least, most
economists would have dismissed it as extremely unlikely.

Tuesday, October 16, 2012

What place has a capital (Capitol?) that is shut off from visitors from the surrounding districts by its security forces? A capital where the loyal elites get to enjoy games and wear colorful dresses for parades, while the workers in the surrounding districts are close to starvation as they produce the products that the central planners require? That world exists only in the Hunger Games...and in North Korea!

Saturday, October 13, 2012

I recently read the great essay "Four Futures" by Peter Frase, in which he lays out a Marxian perspective on what kinds of societies might result in the future from the different combinations of resource scarcity or abundance, and egalitarianism or hierarchy. Quite interesting stuff, although I don't agree with most it.

However, I couldn't resist commenting on one part that directly relates to the title of this blog, where the author discusses the flow of money in the economy:

The bourgeois elite of the present day does not merely enjoy privileged
access to scarce material goods, after all; they also enjoy exalted
status and social power over the working masses, which should not be
discounted as a source of capitalist motivation. Nobody can actually
spend a billion dollars on themselves, after all, and yet there are
hedge fund managers who make that much in a single year and then come
back for more. For such people, money is a source of power over others, a
status marker, and a way of keeping score – not really so different
from Doctorow’s whuffie, except that it is a form of status that depends
on the material deprivation of others. ...But an economy based on artificial scarcity is not only irrational, it
is also dysfunctional. If everyone is constantly being forced to pay out
money in licensing fees, then they need some way of earning money, and
this generates a new problem. The fundamental dilemma of rentism is the
problem of effective demand: that is, how to ensure that people are able
to earn enough money to be able to pay the licensing fees on which
private profit depends.

"Oh, the trouble! Every year one exploits the masses in the production of gadgets and takes their money only to return next year and find out that they have no money left to buy the gadgets!" - That this problem is not actually one encountered in any capitalist societies even though the wealthy earn huge incomes that they don't spend on consumption, should tell us that something is wrong with Frase's idea of how money flows (and many modern Keynesians make the same mistake in their casual writing). Here is the rub: when the rich get all that money every year, there are three things that can happen.

First, and most common, is putting the money in the bank or investing it. This makes the little green paper vouchers for output owned by the rich available for use by others in the present in exchange for the promise of future output vouchers (interest and principal repayments). No demand problem there.

Second, the rich could put the money under their mattress, where no one can access the little paper rectangles. This will result in a lower money supply in the economy, which will either be countered in the short run by the central bank by printing more money or prices will have to adjust downwards by means of retailers trying to get rid of their stock through discounts, until all of the output can again be sold at its nominal price tag. No aggregate demand problem there either. When the rich at some point in the future decide to take the money out from under the mattress, this whole process reverses, the central bank tightens or prices rise and all is as it was before.

Third, the rich could burn the money (those crazy hedge fund managers are capable of anything!). The result would be the same as in the second method above, without the part where the rich get to use the money in the future.

What is definitely not going to happen is that the money simply goes down the rabbit hole and takes the goods it could have bought with it, thereby somehow leading to "material deprivation" of others. If some money is not used to buy goods, then prices do the work of making sure everything gets sold for the little green pieces of paper that are actually circulating. In the long run, the wealth accumulation by the rich might actually be a boon to the economy as a whole! After all, if the rich are not consuming their share of output, they must be investing it, which raises future output and means that everyone else can consume more now and in the future. If it really were the case that we all "overconsumed" before the financial crisis, we should be grateful to the rich who "underconsume" and "overinvest" for makings sure we nonetheless invest in the future. Of course, that is a big "if" about the true origins of the crisis, but in this post I would prefer not to go down that rabbit hole...

Two weeks ago, John Kay was arguing in the Financial Times that the orthodoxy on wages might be deficient. Here is how he describes the status quo:

Economics
101 teaches that earnings reflect marginal productivity. The wage
equates supply and demand for each type of labour, just as the price of
other commodities equates their supply and demand...[T]o set the earnings of any group at a level above the market rate is
not only to reduce employment for that group but to undermine economic
efficiency.

What is the alleged flaw in this textbook approach? The world is so "complex"...:

Complex
modern production is undertaken in teams, and the make-up of an
effective team is largely fixed by the nature of the production process.
It is difficult, perhaps impossible, to attribute output meaningfully
to any particular member. Individual rewards are largely determined by
custom and hierarchy. And through a political process involving
bargaining between shareholders and employees and among different groups
of workers.

This is all pretty unsurprising: workers complement one another and politics sometimes intervenes in the wage-setting process. The implication of the first fact should be that it would be hard to determine theoretically what any one worker should earn and that we should leave that determination to the willingness of employers - who get to practically test that worker's contribution in the context of their respective work teams - to bid for the worker's services. Knowledge is complex and decentralized and prices should therefore be set directly by the market. Conversely, this implies that a political wage-setting process that sets the same wage across many firms might be unable to fully account for these complexities as it excludes any practical consideration of what the worker's productivity is in the context of the specific team and workplace that he is hired into. Leaving this complex calculation of marginal productivities to the employers most immediately concerned via the market wage for individual workers should get us as close as possible to an efficient allocation of workers into the work teams that Kay mentions. Thereby we can maximise productivity and then we can use redistribution, perhaps via lump-sum transfers, to ensure that the fruits of this efficient process are given to those we deem deserving in a manner that does the least damage to the underlying productive process, right?

But John Kay, agreeing with UK Labor Party leader Ed Milliband, seems to draw the exact opposite conclusion:

Wouldn’t it be simpler if poor people in work were just paid more in the first place? That is, apparently, predistribution.

To recap: he argues that it is very complex, even for the employers of the workers in question to figure out what their marginal productivity really is and political distortions make this even harder. And the answer is to abandon market wages and rely on an even more politicized process led by people who have even less of an idea what the productivity of the workers is? Oh, and while you're at it, wages can only go up not down as a result of that process! Unless you're a chief executive that is, because although this is all really "complex", we are very certain that those guys have "excessive earnings", because...well, John Kay says so.

So we would like to make most labor more expensive while making sure that global talent is less well-paid than elsewhere. Sounds like the secret formula for a healthy labor market and strong growth, doesn't it? Just look at Germany in 2003!

About me

I am a US-educated economist from East Germany with experience working as a management consultant in Germany, as well as an economic consultant in New York. This blog is my attempt to read the tea leaves of flows of money, technological change and public policy to understand the world a little better.